What You Need to Know About SPACs
What’s a SPAC ?
SPACs are special purpose acquisition companies, essentially shell companies that raise money from investors through stock-market listings. After going public themselves, they look for private companies to buy. Such transactions make those private companies public without having to go through the traditional initial public stock offering process, which involves “roadshows” to drum up investor interest and an intense media spotlight.
Why SPACs Exist ?
Private companies are willing to be acquired by SPACs because it is more flexible and less burdensome than going public through an initial public offering (IPO).
SPAC acquisitions are also attractive to private companies because their founders and other major shareholders can sell a higher percentage of their ownership in a reverse merger than they would with an initial public offering while also avoiding the lock-up periods that are required for initial public offerings.
A lot of individuals would love to get in early on an IPO before the shares start jumping on fever-pitch demand. But pension funds and professionals usually get there first, leaving them typically picking up the post-offering breadcrumbs and often paying a higher price. So, for retail investors, SPACs are a back door for initial public offering and offer a new opportunity to get in on the action at the beginning.
How SPACs Work ?
SPACs raise capital to make an acquisition through an initial public offering.
A typical SPAC IPO structure consists of a Class A common stock share combined with a warrant. A warrant gives the holder the right to buy more stock at a fixed price at a later date.
Investors who participate in the SPAC IPO are attracted to the opportunity to exercise the warrants so they can get more common stock shares once the acquisition target is identified and the transaction closes.
The typical IPO price for a SPAC common stock is $10 per share. The exercise price for the warrants is typically set about 15% or higher than the IPO price.
A few weeks after the IPO is completed the warrant is spun off and trades separately from the SPAC stock.
At least 85% of the SPAC IPO proceeds must be placed in an escrow account for a future acquisition.
In practice, closer to 97% of the capital raised goes into the escrow account, while 3% is held in reserve to cover IPO underwriting fees and SPAC operating expenses, including due diligence, legal, and accounting fees.
Funds in the escrow account are usually invested in government bonds.
After the IPO, the SPAC’s management team searches for a potential acquisition target. During this period, the SPAC stock should trade near its IPO price since the proceeds are held in government bonds, although during market sell-offs, SPAC stocks can fall below the IPO price.
SPACs can also trade at a premium to the IPO price if shareholders believe management will identify a compelling acquisition target.
SPACs have a specified period to identify an acquisition target and close the deal. The time period is usually two years and called combination date.
If the SPAC sponsor cannot close an acquisition within the given time period, then the money in the escrow account is returned to the shareholders.
If the SPAC sponsors identify a potential target firm, they make a formal announcement. The day the public is notified about the potential acquisition is called the announcement date.
After the announcement, the SPAC sponsors perform additional due diligence and negotiate the acquisition structure. The U.S. Securities and Exchange Commission also reviews the acquisition terms.
The next step is a proxy vote. The SPAC shareholders vote on whether they approve or disapprove of the acquisition. Shareholders also elect whether they want to liquidate their shares in the SPAC for a pro-rata portion of what remains in the trust account.
If a majority of shareholders approve the acquisition then it goes through as long as the number of shareholders who vote to liquidate is below a specified threshold outlined in the proxy statements.
Historically, this percentage was 20%, however, it can be as high as 30% or more.
If more than 50% disapprove of the business combination, then the escrow account is closed, and the proceeds are returned to the shareholders.
SPACs typically target companies about two to four times the amount that was raised in the initial public offering. So, to close the deal, SPACs need additional capital from outside investors. This additional capital is also needed because some of the existing SPAC shareholders would have voted to redeem their shares, taking a portion of the trust proceeds.
SPACs raise both equity and debt to complete the business combination. The equity often comes from leveraged buyout firms, in what is known as Private Investment in Public Equity or PIPEs.
Once the business combination is approved and the additional capital raised, then the transaction closed and the acquired firm is listed on the stock exchange. This day is called merger date.
How to Invest in SPACs ?
Investors can invest in SPACs either by selecting individual securities or by investing in a SPAC ETF.
Selecting individual SPACs allows investors to focus on the opportunities that seem most promising while also having some downside protection due to the structure of SPACs.
Because SPAC IPO proceeds are invested in government bonds until a merger is closed, shareholders have the opportunity to exit the SPAC either through liquidation or by selling shares in the secondary market.
Consequently, SPACs are unlikely to fall below the IPO price until after a merger is closed.
Investors that participate in the SPAC IPO receive both common stock and a warrant. A strategy often pursued by hedge funds is to sell the SPAC after the IPO and keep the warrant that could increase in value if the SPAC stock approaches or exceeds the strike price at which the warrant could be exercised for common stock shares of the SPAC.
What do I need to know before the initial business combination?
Prospectus and reports:
Whether you are investing in a SPAC by participating in its IPO or by purchasing its securities on the open market following an IPO, you should carefully read the SPAC’s IPO prospectus as well as its periodics and current reports filed with the SEC pursuant to its ongoing reporting obligations.
It is important to understand the terms of your investment. While SPACs often are structured similarly and may be subject to certain minimum exchange listing requirements, it is important to understand the specific features of an individual SPAC, including the equity interests held by the sponsor, which may have been obtained for nominal consideration. In addition, given that the SPAC does not have an operating history to evaluate, it is important to review the business background of SPAC management and its sponsors.
Trust account:
In connection with a business combination, a SPAC provides its investors with the opportunity to redeem their shares rather than become a shareholder of the combined company. If the SPAC does not complete a business combination, shareholders are beneficiaries of the trust and entitled to their pro rata share of the aggregate amount then on deposit in the trust account.
You should review the IPO prospectus of the SPAC to understand the terms of the trust account, including your redemption rights and the circumstances in which cash may be released from the account.
Pro rata share of trust account:
One thing to keep in mind is that if you purchased your shares on the open market, you are only entitled to your pro rata share of the trust account and not the price at which you bought the SPAC shares on the market.
For example, if a SPAC had an IPO at $10 per share, but you bought 100 SPAC shares on the open market at $12 per share, the shares you purchased are associated with a trust account balance of about $10 per share, so your share of the trust account would be worth about $1,000 (not the $1,200 you paid for your shares).
Trading price:
In the IPO, SPACs are typically priced at a nominal $10 per unit. Unlike a traditional IPO of an operating company, the SPAC IPO price is not based on a valuation of an existing business. When the units, common stock and warrants begin trading, their market prices may fluctuate, and these fluctuations may bear little relationship to the ultimate economic success of the SPAC.
Period to consummate the initial business combination:
A SPAC will typically provide for a two-year period to identify and complete an initial business combination transaction. However, some SPACs have opted for shorter periods, such as 18 months. The SPAC’s governing instruments may permit it to extend that time period. If a SPAC seeks to extend the time period, it may be required to seek shareholder approval. If a SPAC lists its securities on an exchange, it is required to complete an initial business combination within three years of its IPO.
Warrants:
A SPAC IPO is often structured to offer investors a unit of securities consisting of shares of common stock and warrants. A warrant is a contract that gives the holder the right to purchase from the company a certain number of additional shares of common stock in the future at a certain price, often a premium to the current stock price at the time the warrant is issued.
The terms of warrants may vary greatly across different SPACs, and it is important to understand the terms when investing. Terms of the warrants can include how many shares the investor has the right to purchase, the price at which and period during which shares may be purchased, the circumstances under which the SPAC may be able to redeem the warrants, and when the warrants will expire. To learn more about the specific terms, investors should review the IPO prospectus of the particular SPAC.
What do I need to know at the time of the initial business combination?
Redemption and vote:
Once the SPAC has identified an initial business combination opportunity, the shareholders of the SPAC will have the opportunity to redeem their shares and, in many cases, vote on the initial business combination transaction. Each SPAC shareholder can either remain a shareholder of the company after the initial business combination or redeem and receive its pro rata amount of the funds held in the trust account.
This is an important investor consideration as the SPAC changes from essentially a trust account into an operating company. As an investor, depending on how you view the prospective initial business combination and its valuation, you can decide whether to redeem your shares for a pro rata share of the aggregate amount then on deposit in the trust account or remain an investor in the combined company going forward.
Proxy, information or tender offer statement:
If the SPAC seeks shareholder approval of the initial business combination, it will provide shareholders with a proxy statement in advance of the shareholder vote. In cases where the SPAC does not solicit the approval of public shareholders, because certain shareholders, such as the sponsor and its affiliates, hold enough votes to approve the transaction, it will provide shareholders with an information statement in advance of the completion of the initial business combination.
The proxy or information statement will contain important information about the business of the company that the SPAC wants to acquire, the financial statements of the company, interests of the parties to the transaction, including the sponsor of the SPAC, and the terms of the initial business combination transaction, including the capital structure of the combined entity.
The interests of the sponsor:
SPAC sponsors generally purchase equity in the SPAC at more favorable terms than investors in the IPO or subsequent investors on the open market. As a result, investors should be aware that although most of the SPAC’s capital has been provided by IPO investors, the sponsors and potentially other initial investors will benefit more than investors from the SPAC’s completion of an initial business combination and may have an incentive to complete a transaction on terms that may be less favorable to you.
To learn more about a sponsor’s interests in a SPAC, you should review the “Principal Stockholders” and “Certain Relationships and Related Party Transactions” sections of a SPAC’s IPO prospectus. You can learn more about an initial business combination and the sponsor’s interest in it from the proxy statement, information statement or tender offer statement.